drake drake university fin 286 liquidity risk. drake drake university fin 286 liquidity risk...

69
Drake DRAKE UNIVERSITY Fin 286 Liquidity Risk

Upload: gerald-caldwell

Post on 26-Dec-2015

233 views

Category:

Documents


6 download

TRANSCRIPT

DrakeDRAKE UNIVERSITY

Fin 286

Liquidity Risk

DrakeDrake University

Fin 286Liquidity Risk

Liquidity risk deals with the everyday aspect of doing business.Interest rate risk, credit risk, off balance sheet risk, operational risk all created solvency risk for the FI, liquidity risk generally does not.Liquidity risk represents the risk of the FI not having enough short term liquidity to meet daily operational needs.

DrakeDrake University

Fin 286Causes of Liquidity Risk

Asset sideMay be forced to liquidate assets too rapidly resulting n “fire sale prices”May result from loan commitments

Traditional approach: reserve asset management

FI’s like to reduce cash since cash generally pays little or no interest

Alternative: liability management.

DrakeDrake University

Fin 286Causes of Liquidity Risk

Liability sideReliance on demand deposits

Core deposits (provide long term source of funds)Need to be able to predict the distribution of net deposit drains.Managed by:

purchased liquidity managementstored liquidity management

DrakeDrake University

Fin 286Net Deposit Drains

Deposit withdraws are in part offset by the inflow of new funds and income generated by from both on and off balance sheet activities.The amount by which the cash withdraws exceed the new cash inflows is the Net Deposit Drain.Positive NDD implies withdraws are greater than inflows. Negative NDD implies that inflows are greater than withdraws

DrakeDrake University

Fin 286Net Deposit Drain

The decrease in liabilities must be offset with an increase in liabilities or a decrease in assets if new inflows do not replace the outflow of funding sources.

DrakeDrake University

Fin 286Net Deposit Drain

Predictable Large commercial transaction accounts (payroll etc)Maturing Investments

UnpredictableWill customer reinvest maturing CDLoan commitments

DrakeDrake University

Fin 286Balance Sheet

Before the NDDAssets Liabilities

Assets100 Deposits 70Borrowed Funds

10Other 20

Total 100 100

DrakeDrake University

Fin 286Balance Sheet

After the NDDAssets Liabilities

Assets100 Deposits 65Borrowed Funds 10Other 20

Total 100 95

The most likely way to fix the imbalance is for borrowed funds to increase by 5.

DrakeDrake University

Fin 286Liability Management

Purchased liquidityFederal funds market or repo market.Managing the liability side preserves asset side of balance sheet. Borrowed funds likely at higher rates than interest paid on deposits. Deposits are insuredRegulatory concerns: growth of wholesale fund use as investors have increasing investments and decreasing deposits.

DrakeDrake University

Fin 286Liability Management

Note the tradeoff between funding risk and funding cost.

Demand deposits are a source of cheap funds but there is high risk of withdrawal. NOW accounts: manager can adjust the explicit interest rate, implicit rate and minimum balance requirements to alter attractiveness of NOW deposits.

DrakeDrake University

Fin 286Deposit Accounts

Passbook Savings Accounts: Not checkable. Bank also has power to delay withdrawals for as long as a month.Money market deposit accounts: Somewhat less liquid than demand deposits and NOW accounts. Impose minimum balance requirements and limit the number and denomination of checks each month.

DrakeDrake University

Fin 286Time Deposits and CDs

Retail CDs: Face values under $100,000 and maturities from 2 weeks to 8 years. Penalties for early withdrawal. Unlike T-bills, interest earned on CDs is taxable.Wholesale CDs: Minimum denominations of $100,000. Wholesale CDs are negotiable.

DrakeDrake University

Fin 286Fed Funds

Fed funds is the interbank market for excess reserves. 90% have maturities of 1 day. Fed funds rate can be highly variable

Prior to July 1998: especially around the second Tuesday and Wednesday of each period. (as high as 30% and lows close to 0% on some Wednesdays).

Rollover risk

DrakeDrake University

Fin 286Repurchase Agreements

RPs are collateralized fed funds transactions. Usually backed by government securities. Can be more difficult to arrange than simple fed funds loans.Generally below fed funds rate

DrakeDrake University

Fin 286Other Borrowings

Bankers acceptancesCommercial paperMedium-term notesDiscount window loans

DrakeDrake University

Fin 286

Liability ManagementBorrowing Funds

Advantages:Volume and composition of asset portfolio doesn’t changeCan increase rate to attract fundsOnly borrow IF funds are needed

DisadvantagesMarket determines rateIncreased uncertainty of costs

DrakeDrake University

Fin 286Asset Based Management

Alternative: Stored Liquidity Management Liquidate assets.

In absence of reserve requirements, banks tend to hold reserves. E.g. In U.K. reserves ~ 1% or more. Downside: opportunity cost of reserves.

Decreases size of balance sheetRequires holding excess noninterest-bearing assets

DrakeDrake University

Fin 286Using Cash

The most obvious asset side management technique is to use the cash reserves of the firm.

DrakeDrake University

Fin 286Balance Sheet

Before the NDDAssets Liabilities

Cash 9 Deposits 70Other 91 Borrowed Funds 10

Other 20Total 100

100

DrakeDrake University

Fin 286Balance Sheet

Before the NDDAssets Liabilities

Cash 4 Deposits 65Other 91 Borrowed Funds 10

Other 20Total 95 95

The firm meets the increased withdraws by decreasing its cash balances

DrakeDrake University

Fin 286Cash vs. Liquid Assets

Cash AssetsVault Cash, Demand deposits at Fed Reserve, Demand Deposits at private financial institutions, cash items in the process of collection

Liquid AssetsFed Funds Sold and Reverse Repos, US Treasury and Agency Securities with < 1 yr maturity, Corporate obligations and Municipal Securities with < 1yr maturity, Loans that can be readily sold or securitized.

DrakeDrake University

Fin 286Storing Liquid Assets

If you attempt to store funds in liquid asset they must have

A ready MarketA stable priceReversible (can recover original investment with a high degree of certainty)

DrakeDrake University

Fin 286Costs of using liquid assets

Opportunity cost of foregone earnings if soldOpportunity cost of other assets ( liquid assets have lower return)Transaction costsHigher risk of capital lossWeakens balance sheet position

DrakeDrake University

Fin 286Historical Notes

Since 1960, ratio of liquid to illiquid assets has fallen from about 52% to about 26%. But, loans themselves have also become more liquid. Securitization of DI loansIn the same period, there has been a shift away from sources of funds that have a high risk of withdrawal.

DrakeDrake University

Fin 286Historical Notes

During the period since 1960:Noticeable differences between large and small banks with respect to use of low withdrawal risk funds.Reliance on borrowed funds does have its own risks as with Continental Illinois.

DrakeDrake University

Fin 286Final alternative

It is also possible and likely that the FI can combine purchased and stored liquidity management techniques.

DrakeDrake University

Fin 286Asset Side Liquidity Risk

Risk from loan commitments and other credit lines:

met either by borrowing funds or by running down reserves

Current levels of loan commitments are dangerously high according to regulators

DrakeDrake University

Fin 286

Measuring Liquidity Exposure

Net liquidity statement: shows sources and uses of liquidity.

Sources: incoming deposits, revenue from sale of non deposit services, Customer Loan repayments, Sale of bank Assets, Borrowing in money marketUses include: Deposit Withdraws, Volume of Acceptable loan requests, repayments of bank borrowing, other operating expenses, dividend payments

DrakeDrake University

Fin 286Other Measures:

Peer group comparisons: usual ratios include:

borrowed funds/total assets, loan commitments/assetsLoan Losses / Net loansTotal Deposits./ Total AssetsCore Deposits/Total AssetsFed Funds Purchased / Total AssetsReserve for Loan losses / Net Loans

DrakeDrake University

Fin 286

Liquidity index: weighted sum of “fire sale price” P to fair market price, P*, where the portfolio weights are the percent of the portfolio value formed by the individual assets. I = wi(Pi /Pi*)

DrakeDrake University

Fin 286Measuring Liquidity Risk

Financing gap and the financing requirement:Financing gap = Average loans - Average deposits or,

financing gap + liquid assets = financing requirement.The gap can be used in peer group comparisons or examined for trends within an individual FI.

DrakeDrake University

Fin 286BIS Approach:

Maturity ladder/Scenario AnalysisFor each maturity, assess all cash inflows versus outflowsDaily and cumulative net funding requirements can be determined in this mannerMust also evaluate “what if” scenarios in this framework

DrakeDrake University

Fin 286Liquidity Planning

Important to know which types of depositors are likely to withdraw first in a crisis. Composition of the depositor base will affect the severity of funding shortfalls. Allow for seasonal effects. Delineate managerial responsibilities clearly.

DrakeDrake University

Fin 286Bank Runs

Can arise due to concern about bank’s solvency.Failure of a related FI.Sudden changes in investor preferences.Demand deposits are first come first served. Depositor’s place in line matters.Bank panic: systemic or contagious bank run.

DrakeDrake University

Fin 286Alleviating Bank Runs:

Regulatory measures to reduce likelihood of bank runs:

FDICDiscount window

Not without economic costs.

DrakeDrake University

Fin 286Liquidity Risk for Other FIs

Life Cos. Hold reserves to offset policy cancellations. The pattern is normally predictable.An example: First Capital in California, 1991.CA regulators placed limits on ability to surrender policies.Problem is less severe for P&C insurers since assets tend to be shorter term and more liquid.

DrakeDrake University

Fin 286Mutual Funds

Net asset value (NAV) of the fund is market value. The incentive for runs is not like the situation faced by banks. Asset losses will be shared on a pro rata basis so there is no advantage to being first in line.

DrakeDrake University

Fin 286

Liability and Liquidity Management

Depository institutions and life insurance companies are highly exposed to liquidity risk.The second half of the liquidity risk portion of class discusses how these firms can control liquidity risk, the motives for holding liquid assets, and specific issues associated with liability and liquidity risk management.

DrakeDrake University

Fin 286Liquid Assets

Liquid assets are assets that can be turned quickly into cash

Low transaction costsLittle or no loss in principle valueTraded in large market (trading does not move the market)

DrakeDrake University

Fin 286Liquid Asset Management

Examples: T-bills, T-notes, T-bondsBenefits of holding large quantities of liquid assets

Low risk (except for inflation risks)Flexibility in meeting liability claims

Costs of holding liquid assetsLost interest income

DrakeDrake University

Fin 286

Liquid Asset Management: Reserve Requirements

Reasons for regulating minimum holdings of liquid assets:

Monetary policyEnables Monetary policy by forcing Depository Institutions to participate in the Central Banking System.TaxationForcing a reserve requirement places a form of Tax on the Depository InstitutionFacilitates Clearinghouse Function

DrakeDrake University

Fin 286

Liquid Asset Management: Reserve Requirements

Use of Reserve Requirements as a monetary Policy tool has decreased.

Fed’s new emphasis on the control of short term interest ratesUse of Sweep Accounts Sweep Account – contractual agreement between bank and depositor permitting the bank to switch funds from checking account to an interest bearing account (decreased reserve requirement)

DrakeDrake University

Fin 286Composition

Composition of liquid asset portfolioBreakdown between cash and other securitiesDetermined by regulations by government and earnings of the firm

Liquid assets ratio=Liquid Assets / Total Assets

Cash and government securities in countries such as U.K

Similar case for U.S. life insurance companies (regulated at state level)U.S. banks: cash-based, but banks view government securities as buffer reserves.

DrakeDrake University

Fin 286

U.S. Cash Reserve Requirementsfor Depository Institutions

Incremental reserve requirements for transaction accounts (all deposits on which account holders can make immediate withdrawals):

First $5.5 million 0.0%$5.5 million to $42.8 million 3.0%$42.8 million + 10.0%

DrakeDrake University

Fin 286Lagged Reserve Accounting

The system for calculating and maintaining reserves is based on a lagged reserve accounting system. In the system the computation of the reserves and the reserve maintenance period do not overlap.

DrakeDrake University

Fin 286

Reserve Management Problem

Computation period runs from a Tuesday to a Monday, 14 days later.First a period for transaction balances, then a cash computation period. Reserves based upon the balance must be maintained over a Reserve Maintenance Period.Average daily reserves are computed as a fraction of the average daily deposits over the period.

DrakeDrake University

Fin 286

Lagged Computation PeriodBank Vault Computation Period

Sun Mon Tues Wed Thurs Fri Sat

Sun Mon Tues Wed Thurs Fri Sat

Sun Mon Tues Wed Thurs Fri Sat

Sun Mon Tues Wed Thurs Fri Sat

Sun Mon Tues Wed Thurs Fri Sat

Sun Mon Tues Wed Thurs Fri Sat

Sun Mon Tues Wed Thurs Fri Sat

Reserve Maintenance Period

DrakeDrake University

Fin 286Reserve Management

The reserve maintenance period, differs from the computation period by 17 days.

Lagged reserve accounting as of July 1998.Previously, contemporaneous (2-day lag).

Benefits and Costs of lagged reserve accounting

Provides certainty for banks in terms of holdingsEasier to manage reserves.Slows down monetary policy

DrakeDrake University

Fin 286Undershooting/Overshooting

Allowance for up to a 4% error in average daily reserves or $50,000 which ever is greater without penalty.

Surplus reserves required for next 2-week period

Undershooting by more than 4% penalized by a 2% markup on rate charged against shortfall. Frequent undershooting likely to attract scrutiny by regulators

DrakeDrake University

Fin 286Costs of Undershooting

Explicit CostIf undershooting by more than 4% the DI is subject to an interest penalty equal to 2% plus the discount rate

Implicit CostIncreased scrutiny by regulatorsIncreased monitoring, examinations and surveillance

Opportunity CostsBenefit of undershooting is avoiding high opportunity costs of holding more reserves than necessary instead of loans etc..

DrakeDrake University

Fin 286Undershooting

DI has two options near the end of the maintenance period to increase reserves

Liquidate less liquid assets or buffer reservesBorrow reserves

Fed FundsDiscount windowrepurchase agreements

DrakeDrake University

Fin 286Discount Window

Designed to cover surprise shortfallsDiscount window borrowing

Discount rate usually lower than market ratesMeant to be used on a when needed basis and not used for profit.

Risks of gaming the system“Gaming” claiming that short reserves are the result of sudden liquidity crunches then using the difference in the discount rate and market rates to profit. If caught charter can be revoked.

DrakeDrake University

Fin 286Overshooting

First 4 percent can be carried forward to next periodExcess reserves typically low due to opportunity costsKnife-Edge problem

Either under or over shooting can be costly to the institution and to the career of the manager of the liquidity position.

DrakeDrake University

Fin 286Managing Liquidity

When calculating reserves, Friday deposit figures count 3 times in the average. (used for Friday, Saturday and Sunday)“Weekend Game”

Transferring foreign deposits to foreign subsidiaries for the weekend effectively lowers the total reserves required.

DrakeDrake University

Fin 286Sweep Accounts

Weekend ProgramSweeping transaction deposits to money market or savings accounts at the close of business on Friday and returning the balance Monday.Eliminates need for reserves on that amount for Friday, Saturday and Sunday

DrakeDrake University

Fin 286Seep Accounts

Threshold AccountsFunds are swept to a different account when the account exceeds a minimum level. Regulation D – limits the number of withdraws or transfers to 6 a month.If more than 6 withdraws or transfers the account is classified as as an ATS (automatic transfer to savings) and is subject to Reserve Requirements

DrakeDrake University

Fin 286Business Sweep Accounts

Regulation Q prohibits paying explicit interest on business demand depositsCommercial sweeps – moves money overnight (not counted as reserves at end of business day) into non interest earning assets (repos for example). Funds loose FDIC insurance.

DrakeDrake University

Fin 286Return-Risk Trade-off

Cash immediacy versus reduced returnConstrained optimization

Privately optimal reserve holdings Regulator imposed reserve holdings

DrakeDrake University

Fin 286Liquidity Management

Liquidity can be managed from either the asset side of the balance sheet or the liability side. Asset based management

Main goal is storing liquidity in the form of liquid assets.Less risky and often used by smaller institutionsCosts

Opportunity cost of foregone earnings if soldOpportunity cost of liquid assetsTransaction CostsWeakened Balance Sheet

DrakeDrake University

Fin 286Liquidity Management

Raising funds via borrowing if needed

AdvantagesOnly borrow if funds are neededVolume and composition of asset portfolio is unchangedCan always attract funds (by increasing rate)

DisadvantagesDependent upon market rateWithdrawal risk (funding risk)

DrakeDrake University

Fin 286Funding Risk versus Cost

Funding Cost

Funding Risk

DrakeDrake University

Fin 286Choice of Liability Structure

Demand DepositsHigh Withdrawal riskLow costs – interest costs are low, but service costs can be high

Interest Bearing NOW AccountsNegotiable order of withdrawal accounts. Pay interest on checkable deposits, but require minimum balanceHigh withdrawal riskHigher costs due to interest expenses. Can be managed by changing the minimum balance

DrakeDrake University

Fin 286Choice of Liability Structure

Passbook SavingsNoncheckable and usually require physical presence for withdrawalLower withdrawal risk. Institution has the right to delay withdrawal requests for up to one month.Pay a higher interest rate than NOW accounts

Money Market Deposit AccountsRetail savings accounts with limited check writingDI do not hold reserves against MMDA’sCompete with MMMF for funds

DrakeDrake University

Fin 286Choice of Liability Structure

Retail Time Deposits and CD’s (<100,000)

Structured to reduce withdrawal risk

Wholesale CD’s (>100,000)Depositors can sell their positions in the secondary market instead of withdrawing funds.

DrakeDrake University

Fin 286Choice of Liability Structure

Federal Funds and ReposSince they are borrowed funds there are no reserve requirementsSubject to settlement risk

Other borrowingsCommercial paper – issued by holding companies, no the DIMedium term NotesDiscount Window Loans

DrakeDrake University

Fin 286Liability Structure

1960 2001 2001 2001

LiabilityAll

banksAll

BanksLarge Banks

Small Bank

s

Transaction Accounts 61% 9.7% 9.8%11.8

%

Retail CD’s and time Deposits

29% 40%38.2

%54.6

%

Wholesale CD’s 015.5

%9.6%

12.5%

Borrowings 2%28.2

%34.2

%10.1

%

Bank Capital 8% 6.6% 8.2% 11%

DrakeDrake University

Fin 286

Balanced Liquidity Management

Combination of Asset and Liability ManagementBorrow only for unanticipated (usually short term needs)Plan for long term liquidity needs via asset management.

DrakeDrake University

Fin 286Liquidity Risk in Other FIs

Insurance companiesDiversify across contractsHold marketable assets

Securities firmsExample: Drexel Burnham Lambert and Junk Bonds